The definition of the Interest Coverage Ratio is simple enough. It is the EBIT divided by interest expense:

EBIT is the earnings (or Profits) before interest and tax payments. It is calculated by adding the interest expense to the PBT (Profits Before Tax). The PBT and interest figures can be obtained from the Profit and Loss statement in any Annual Report of a company.

What does that mean? Maharashtra Seamless can pay its debt obligation 34 times with its earnings before interest and taxes. Let us look at another company - 3i Infotech, which is quite popular with small investors.

PBT was 288.5 Cr; interest expense was 95 Cr for year-ending Mar '09. EBIT = 383.5 Cr, not much lower than that of Maharashtra Seamless. But the difference in the interest coverage ratio is startling - an adequate 4, against a very comfortable 34!

An interest coverage ratio of less than 1.5 means that the company may have trouble meeting its debt obligations and may need to borrow more to pay its previous debts. A ratio less than 2.5 should be treated as a warning sign. Avoid companies with a ratio less than 1.

It is important to check a company's financial health over the past 5 years or more. A decreasing interest coverage ratio - even if it is above the threshold values mentioned - is a red flag. Look for companies with consistency of earnings. They can afford to have a lower interest coverage ratio - though the higher the ratio, the better their financial health.

Conservative investors can use a more stringent ratio, by using only EBI on the numerator. That is, they should deduct the tax amount from EBIT before calculating the Interest Coverage Ratio.

This concludes the series of posts on how to evaluate the financial health of a company. Readers may want to go through an exercise of calculating the financial soundness of stocks in their portfolios. The time spent will be well worth it.

8 comments:

Thanks sir once again for another lovely write-up. I was wondering how relevant are the ratios cited in the Little Book That Beats The Market ... Return on capital which is EBIT/(Net working capital+Net Fixed Assets) and Earnings Yield which is EBIT/Enterprise Value.Are these covered in some way in the ratios you have covered?Thanks so much sir ... as always! :)

sir,i have a doubt,we do our best ascertaing various facts and figures available on various public forums like bse,nse,etc. to analyse a company.How to make sure that the information submitted by those companies to various regulators is reliable and fair?Let's take an example of satyam computers, if anyone would have analysed the data and figures submitted to exchanges like 6000crs cash(actually fudged figures),instantly any investor would love to have this scrip in their portfolio.As far as management is concern,Raju was said to an honest person was coveted with many awards by many reputed organisations.For investors also its like riding a tiger(Raju's word)with fear of falling in stock market.mansoor panjwani

I've so far covered the ratios related to the financial health of companies. Those are what I prefer to check first.

Will cover profitability ratios (like RoC) in future posts.

@tax_trp: Good point, Mansoor. We have no choice but to accept audited accounts in the Annual Report as correct. It is a major reason why it is safer to invest in market leaders with proven management integrity - like the Tatas, Mahindras, ITC, Infosys.

In the case of Satyam (which was No 4 in IT services with a promoter from real-estate background), the cash balances in the cash flow statement and the Balance sheet did not match. They hoodwinked the auditors by producing false bank Fixed Deposit certificates.

It is easier to fudge the earnings, because profits can be 'booked' on various pretexts. The cash flows are more difficult to fake.

Dear Master,I do agree with Coverage ratio, and similary there are various ratio and gauges to evaluate a company. What are the ratios/numbers are very important as like cash flow and in which order of importance ? Normally on what order do you check for financial check of a company .

Imagine a house with lots of windows. You get a different view from each - but the world outside is the same. The different ratios give different views of a company's functioning.

I prefer to look at the financial health ratios first (in the order of the blog posts). Most companies fail to meet the threshold limits that I set. For companies that get through the first screening, I look at efficiency and profitability ratios.

These are my preferences. You may want to look at the ratios in a different order.

@Sumanta: Appreciate the comments and suggestion.

I'm working on an eBook that has a compilation of some of my earlier articles. I will announce it on my blog when it is ready. Please bear with me.

I've no doubt that you'll find the exercise rewarding. If you wish, you can share your conclusions with me privately.

Subhankarji, In one of your replies, you have mentioned "The cash balances at the bottom of the cash flow statement shouldmatch with that in the Balance Sheet".Could you please explain more on the statement?ThanksRishi